COST OF PRODUCTION, Part 1
Businesses are concerned about a lot of things, but profit maximization is the ultimate goal for most firms.  To maximize profits, a business can try to increase revenue, decrease costs, or do a mixture of both.  In this lesson, you are going to learn about the costs firms face when doing business.

There are three types of costs:  Fixed Costs, Variable Costs, and Total Costs. 

FIXED COSTS

Fixed Costs are those costs that remain constant whether ZERO units are produced or a ZILLION units are produced.

So before anything is produced, a business owner will have Fixed Costs. 

The first thing an honest business person does is get a business license.  In many cities, the owner pays a minimal flat fee to receive the "business privilege license" and then the business owner pays a quarterly fee to the government to hang the business license on the wall.  So before producing anything, the business owner has an expense. 

The next thing an owner does is to find a facility to produce or sell his or her good or service.  The business owner pays rent or mortgage on the store, warehouse, or factory, before producing a single item. 

The owner has already or will purchase machinery and equipment for the business.  Many times a business owner will take out a loan for these items as to have cash on hand for emergencies.  The loan payments remain constant, thus a Fixed Cost.

If the business owner hires a salary worker, this is a Fixed Cost to the firm because the firm has entered into a contract with the salary worker and whether zero units are produced or a zillion, the salary worker gets paid the same amount.

VARIABLE COSTS

Variable Costs are those costs that change (increase) as output changes (increases).

As output increases, more wage workers are hired, more supplies are ordered, more utilites are used, and so on.  Costs that change with a change in output are Variable Costs.

TOTAL COSTS

Total Costs are = Fixed Costs + the Variable Costs.

                                                                               COST CURVES

As you recall, Fixed Costs remain constant, whether 0 units are produced or a zillion units are produced.  This is why the FC curve in the graph below is horizontal.  Most businesses lose money when they start out because they have certain FC before they produce anything.  In the graph, if you were to draw the FC line to the Y axis, you know at zero units, you still have Fixed Costs of $1,000.

The Variable Costs continue to rise as output rises (more supplies are needed).  Variable Costs do NOT start at zero though.  The only cost you have at zero are your Fixed Costs.  Your Variable Costs begin to rise as you start production with the 1st unit of production.

The Total Costs are the Fixed Costs + the Variable Costs.

                                                                            






The table and graph above indicate what happens to AFC (Average Fixed Cost), AVC (Average Variable Cost), ATC (Average Total Cost), and MC (Marginal Cost) as output rises.

Take your mouse and run it down each of the following columns:  AFC, AVC, ATC, and MC.

AFC--Notice as output rises, the AFC continues to fall.  The reason is as FC (those costs that remain constant) are divided by a larger and larger Q as output increases, then the AFC continues to fall because a constant number is being divided by a larger and larger number.

AVC--Notice on the table above that VC continues to go up, but AVC starts downward and then at the 10th unit, the AVC begins to rise.

ATC--Notice on the table above that TC continues to go up, but ATC starts downward and then at the 13th unit, the ATC begins to rise.

Notice on the graph above, as MC goes down, AVC and ATC definitely go down.
However, notice as MC rises and is BELOW AVC or ATC, the AVC and ATC continue to go down, but at a decreasing rate.
Notice MC touches AVC and ATC at their lowest points.
Notice as MC rises and is ABOVE AVC and ATC, the AVC and ATC also go up. 

 
The graph above shows the Average Fixed Cost of doing business at various quantities.  When you take your mouse and rollover the yellow dots on the graph, you can figure the total Fixed Costs by multiplying the Average Fixed Cost times the quantity.  Notice the AFC continues to go down as more units of output are produced, but the total Fixed Costs (FC) remain constant at each unit of output.
 
The graph above shows the Average Fixed Costs Curve (AFC), Average Variable Costs Curve (AVC), and Average Total Costs Curve (ATC).  When you take your mouse and move it along the black dots on the AFC, notice how the AFC is equal to the distance between ATC and AVC.  From this, you can deduct that AFC = ATC - AVC.  From now on, when you draw cost curves, you will only have to draw the ATC, AVC, and the MC curves.  The reason you don't have to draw the AFC curve anymore is you can figure what the AFC is at any quantity by taking ATC and subtracting AVC to get AFC.
 
The graph above shows only the ATC and AVC curves.  When you take your mouse and run it down the AVC column on the table, you can see that the total VC continue to rise as output rises, but AVC declines until output 10 and then begin to rise. 
 
The graph above shows only the ATC and AVC curves.  When you take your mouse and run it down the AFC and AVC columns on the table, you can see that the total VC continue to rise as output rises, the total FC remain the same as output rises, and TC rises by $1,000 more than the VC.
 
Most newcomers to economics would think the graphs with TOTAL in them are an important models in economics.  They aren't.   The graphs that are most important in learning cost curves in economics are the graphs with AVERAGE and MARGINAL cost curves.  You see, if you know the AVERAGE, then you can figure the TOTAL.  For example, let's say you have taken four exams and your average on those exams is 80.  What is your TOTAL?  320.  If you know the AVERAGE (in this case, 80), you take the AVERAGE and multiply it times the quantity (in this case, four) to get 320.  So, again, if you know the AVERAGE, you can always figure the TOTAL by multiplying the AVERAGE times the quantity.
On the graph above, take your mouse and move it along the black dots on the FC curve.  You can see that the distance between the TC and the VC are your FC.  (NOTE:  It might look like an optical illusion, but the FC between the TC and the VC are identical to the FC of $1,000 whether you produce 5 units or 17 units.) 

All of the following formulas then are true statements regarding the information in the graph above:

TC = FC + VC
FC = TC - VC
VC = TC - FC
In the next lesson on Costs, Part II, you will learn why:

MC touches AVC and ATC at their lowest points.
MC, VC, and ATC will change if there is a per-unit tax or subsidy.
Only ATC will change if there is a lump sum tax or subsidy.